World economy: EIU global forecast - Higher interest rates are coming

February 13th 2018

FROM THE ECONOMIST INTELLIGENCE UNIT

After an encouraging 2017 for the global economy, The Economist Intelligence Unit expects 2018 to proceed along similar lines. The US economy will continue to motor along; the euro area will absorb more of labour market slack; the Chinese government will manage its economic slowdown carefully; and Japan's economy will grow by 1.5%. Higher commodity prices will prove a fillip for emerging-market exporters, as will strong external demand from developed markets. However, 2018 will also be characterised by tightening monetary policy and credit conditions. On balance, the global economy is forecast to expand by 3% in 2018 and 2.9% in 2019, from an estimated 3% in 2017.

Over the next two years the European Central Bank (ECB) will continue to taper its quantitative easing (QE) purchases ahead of a first interest-rate rise in 2020, and we believe that the Bank of Japan (BOJ) will also begin to wind down QE, beginning in 2019. Over these two years there will also be monetary tightening in Canada, the UK and Australasia. Higher borrowing costs in major economies will force other central banks in emerging markets to fall into line. By reducing long-term yields through QE, investors have been forced to look elsewhere for attractive returns. This excess liquidity has pushed up the prices of all manner of assets, including bonds, stocks and property, generating a major risk for the health of the global economy.

It also needs stressing that the effects on financial markets of withdrawing huge amounts of monetary stimulus are not well understood. The Federal Reserve (Fed, the US central bank) is doing its bit to minimise the disruption by outlining how it will taper its QE programme. The ECB and the BOJ are likely to use the same strategy, but the impact on financial markets remains unclear. February's jitters are likely to represent the end of a period of unusual calm in financial markets. We expect there to be further short-lived periods of volatility as global markets adjust to the gradual shift away from easy money.

The business-cycle downturn that we expect in the US in 2020 has become the defining event in our forecast period. It is likely that the long period of economic growth will be interrupted in the coming years. The unemployment rate that is consistent with non-accelerating inflation is very low, at between 3.5% and 4%. Our view of this rate is lower than that assumed by the Fed (4.5%), meaning that inflationary pressures will take longer to build, even allowing for the mild stimulatory effect of the tax-reform package passed in late 2017. With inflation and the pace of monetary policy tightening accelerating, the pressure will be greater than the economy can bear, and we expect private consumption and investment to contract for two quarters in early 2020. Our core forecast is that the dip will be shallow and the rebound relatively rapid, owing to the Fed cutting interest rates aggressively in response to the contraction and some support from fiscal stimulus measures. This means that the recovery in 2021‑22 will be brisk.

Against the backdrop of a healthy global economy lies the highest level of political risk in years. The US is sending an ambivalent message to its traditional allies, following its withdrawal from the Paris climate agreement and the Trans-Pacific Partnership, and its stance towards NATO. It is, however, the US's heated rhetoric towards North Korea that could have the greatest potential consequences. Although both sides have a strong incentive not to escalate the situation, we note the small risk of North Korea unleashing its nuclear capability under the belief that a US assault was imminent, or the US attempting to warn off North Korea through a "bloody nose" attack.

Developed world

The US economy is in good shape, and we have revised up economic growth in 2018 to 2.5%, from 2.3% previously. Wage growth is showing signs of accelerating, and the unemployment rate is at its lowest level since 2000. We expect the US economy to show signs of overheating in the next two years, as a result of which the Fed will quicken the pace of monetary tightening, especially given the recent tax changes. Unable to cope with this, the economy will face a downturn in early 2020. The recent revival of the euro zone economy is likely to be sustained, but political risk will remain high. EU leaders are currently boosting the region's resilience to shocks, in part by renewing their push for further integration of the economic and monetary union. A decision on reform proposals will be made at the EU summit in June 2018. Following the renewed landslide secured by the ruling Liberal Democratic Party (LDP) in Japan, Shinzo Abe is in a strong position to secure another term as LDP leader when the party votes in late 2018. This comes in the context of the country's mild economic recovery under the prime minister's recovery plan.

Emerging markets

We expect conditions for emerging markets to become more challenging in the first half of the forecast period as US interest rates continue to rise. India will be Asia's fastest-growing large economy in 2018‑22, expanding at an average annual rate of 7.9%. Growth will also remain on track in the Association of South-East Asian Nations (ASEAN) member states, with an average annual expansion of 4.8%. Vietnam, Cambodia and Myanmar, in particular, will continue to record growth rates above 6%, owing to relatively low wage costs and advantageous geographic locations.

We expect the Chinese economy to slowly slightly in 2018, to 6.4%, from an estimated 6.9% in 2017. The government's long-held target of doubling real GDP between 2010 and 2020 is within its grasp; it requires annual average GDP growth of 6.3% in 2018‑20. We believe that it will meet this target without requiring significant economic stimulus. We expect China to move away from GDP targeting in the next decade. This is ideologically consistent with the call of the president, Xi Jinping, for more inclusive growth in his landmark speech at the party congress at the end of 2017. As such, we expect growth to continue to slow steadily in the forecast period, reaching 5.2% in 2022.

The ongoing economic recovery in Latin America is forecast to gather momentum in 2018‑19, after several years dominated by macroeconomic policy adjustments to the end of the commodities boom of the previous decade. Sustained Chinese growth will continue to provide a favourable external environment for the region, particularly for commodity exporters such as Brazil and Argentina. This, combined with a rise in global risk appetite, as reflected in lower sovereign credit default swap rates (except for Venezuela, which defaulted on some external debt obligations in late 2017, taking the country further into economic and financial crisis), has generated strong growth in local stockmarkets.

At present, seven countries in the Middle East that collectively account for a quarter of the regional population are either torn by civil war or destabilised by Shia-Sunni rivalry. Geopolitical risk has also risen rapidly within the Gulf Co‑operation Council (GCC). We expect the boycott of Qatar by some of the GCC countries and Egypt to continue until at least 2021. In this period divisions will harden between Qatar, Turkey and Iran on one side, and Saudi Arabia, the UAE and Egypt on the other. The long-term rivalry between Saudi Arabia and Iran is likely to destabilise a group of other countries in the Middle East, including Iraq, Syria, Lebanon and Yemen. Tensions are likely to increase rather than diminish in the region in the coming months.

Following a dismal performance in Sub-Saharan Africa over 2016‑17, we expect a lacklustre recovery to take hold from 2018. This will be driven by a favourable external environment as export prices strengthen and trade gathers pace. However, policy mismanagement, unsupportive political dynamics and gradual tightening of credit conditions in developed economies will weigh on future prospects. On balance, the region is forecast to grow by 3.3% a year in 2018‑22.

Exchange rates

The US dollar has continued to depreciate in early 2018, in spite of solid economic data, major tax reform and a clear commitment by the Fed to raising interest rates. Previously, markets did not believe monetary tightening by the Fed to be credible. However, this changed in early February when global stockmarkets fell sharply in response to suggestions of faster US wage growth. Regular interest-rate increases should provide the dollar with fresh support over the next two years, but any rally in 2018‑19 will be modest at most. Among G10 currencies, the euro made the biggest gains against the dollar in 2017 as economic data went from strength to strength and some political risk receded. Further supporting the currency, the ECB is slowly becoming more upbeat in its communication. However, we believe that the first interest-rate rise is still two years away, and the euro zone continues to face considerable political challenges, which will limit economic momentum. On balance, we expect the euro to hold steady against the dollar in 2018‑19. The yen is expected to appreciate further against the dollar in 2018‑19 owing to its safe-haven appeal, and as the BOJ slows the pace of its asset purchases over dwindling bond-market liquidity concerns.

Commodities

The price of crude oil is likely to remain range-bound, at US$60‑70/barrel in 2018‑19 for dated Brent Blend, despite the efforts of OPEC and its partners, notably Russia, to constrain global supply by extending the existing production-cut deal until the end of 2018. These efforts will be largely offset by US shale, which will provide both a price ceiling and a floor. Industrial raw materials prices are set to rise for a second successive year in 2018 on the back of strong growth in China and strict environmental controls restricting supply. We expect marginal growth in food, feedstuffs and beverages prices, reflecting rising population, incomes and rapid urbanisation.